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6.

THE COST OF CAPITAL


part I

Chapter 5

The cost of capital


There are costs connected with obtaining financing and
compensating providers of various sources of funds, both
short-term and long-term, which must be considered by
management in making any financing decision.
One of managements obligations is to develop a pattern of
funding that both matches the risk/reward profile of the
business and is sufficiently adapted to meeting the
evolving needs of the company.

The cost of capital

This section describes the procedures for measuring the cost of


specific sources of capital.
Our concern is only with the long-term sources of funds available
to a firm, since these sources supply the permanent financing.
There are four basic sources of long-term funds for the business:
1. long-term debt;
2. preferred stock;
3. common stock;
4. retained earnings.

The cost of capital


The right side of a balance sheet can be used to illustrate these
sources.

1.

Cost of Bonds

Together with the equity and the financing by means of bank


loans, important sources of financing from outside the company
are attracted appealing to the public savings that is the bond
financing.
For any company, in some situations, the equity is insufficient to
cover the financing needs, and its growth (by new cash
subscription or by the incorporation of the reserves) may
encounter difficulties, not only from the juridical point of view but
mostly from the inherent risks related to the potential investors
trust in the issuer of shares and those related to the possibility of
loosing control for the old shareholders.

1. Cost of bonds

In addition to that, contracting bank loans implies for the company,


sometimes, more restrictive conditions to be fulfilled. These are the
reasons that determine the companies, especially the big ones that
are marketable, to apply to bonds financing.

A bond is a security sold by governments and corporations to raise


money from investors today in exchange for the promised future
payment.
Corporate bonds are certificates evidencing that the company has
borrowed a specified sum of money, which it has promised to repay in
the future under clearly defined terms.
Bonds are long-term debt instruments used to raise large sums of
money from a diverse group of lenders.

1. Cost of Bonds

We can define the bond as a security that proves a medium or long


term loan that the issuer obliges to repay in a determined period of
time, that gives the right to its owner (the creditor of the firm) to a
certain annual interest, during the whole period, no matter the
economic or financial situation of the issuer.

There also exist convertible bonds that can be turned/changed in


shares of the firm that issued them, in the conditions established in
the public offer prospect.
At first sight, one might appreciate that a total capital growth by
means of the issue of bonds has a bad influence on the firms
financial structure toward the growth of the balance of debts in the
total capital.

1. Cost of bonds

There are several conditions to be fulfilled by a firm in order to have


access to bonds financing market:

- it has to be a joint-stock company;


- the firm has to have at least two or three years of activity
reflected in the balance sheet approved by the shareholders;
- the issue of bonds by public offer is made on the basis of a
prospect of issue;
- the value of the subscribed bond financing has to be completely
subscribed.

1. Cost of Bonds (parameters of the issue)


The issuing company of the bonds establishes, through consulting with
the mediation company and based on its own needs of financing the
characteristics (parameters) of the issue:
1. the face value (or par value) of the bond equals the part of the
borrowed amount, represented by each bond. The bonds from the same
issue must be of an equal value, to give the owners equal rights.
2. the emission price (issue price) represents the amount paid by the
buyer to become the owner of the bond. In some cases, the issue price
equals the face value, and in other situations (for example, the need to
speed up the bond sale), there is a difference between the face value
and the issue price (the face value may be bigger than the issue price).
The difference is called issue premium.

1. Cost of bonds (parameters of the issue)


Sometimes, to make the bonds more attractive, or when the
period is big, they are returned when due time at a bigger price
than the par, the difference being called returning/repayment
premium. The issuing and returning premiums decide a cost of
the credit higher than the nominal interest. When the issue of
bond financing is under-par, and its return is at a higher value than
the par, both an issue premium and a returning premium will
appear.
3. the numbers of bonds.
4. the total amount of the bonds financing, is obtained by
multiplying the issue price with the numbers of bonds. This is the
amount which is used to finance the firm.

1. Cost of bonds (parameters of the issue)

5. the date of use is the date when the interest begins to


flow.
6. the date of regulation is the date when the investors
deposit the amounts for the bonds financing.
7. the amount of the interest. The issuer remunerates the
borrowed amounts, with a periodic interest. The promised
interest payments of a bond are called coupons. The bond
certificate typically specifies that the coupons will be paid
periodically (for example, semiannually) until the maturity
date of the bond. The amount of each coupon payment is
determined by the coupon rate (interest rate) of the bond.

1. Cost of bonds (parameters of the issue)

This coupon rate is set by the issuer and stated on


the bond certificate. The amount of each coupon
payment, CP, is:

For example, a $1000 bond with a 10% coupon rate and semiannual payments
will pay coupon payments of $100010% / 2 = $50 every six months.

1. Cost of bonds (parameters of the issue)


8. the life period, the frequency of payments and the
returning modalities. In the financial practice, there are used
many returning ways. A bond may have one or more
specifications for amortization. Generally there are:
a) the normal amortization of the loan;
b) the amortization with specifications for the return with
anticipation.

The cost of the bond credit

The real cost of the bond loans is given by the discount


rate (r) that equals the net present value (NPV) of this
operation with zero, as follows:

I0 - the initial cash flow (cash flow at the beginning of year 1)


CFi the annual cash flows that occur during the loan period

The cost of the bond credit

When estimating the annual cash flows we will keep in mind:


the returning modalities (if the reimbursement is made entirely
and the end of those n years; proportionally in time; or in more
delicate situations, uneven in time).
the incidence of the profit taxes.

In this way, under the incidence of the taxes, the interests are
deductible of the taxable profit and the real load undertaken by
the company is smaller, that is if the debtor company is
profitable, the interest that it will deliver each year to its lender
will allow realizing tax shield.

The cost of the bond credit

If we consider a company that emits N bonds, with the face


value FV and with the emission price PE, with PE < FV,
the effective cashed amount is N * PE.
If the emitted bonds are reimbursed at a repayment price PR,
with PE < FV < PR, the company has the possibility to diminish
the amount of the taxable profit with the issuing and returning
premiums.
If the company reimburses the respective amount of Ni
obligations in the year "i", it can diminish the taxable profit with
an amount equal to the emission and returning premium
paid to these bonds:
Ni * (P R - PE).

The cost of the bond credit

This calculated diminish allows if the company is


profitable, to accomplish a tax shield:
Ni * (PR - PE)* T
So, the cost of bonds credit, r, obtained with emission and
repayment premium, is the solution of the following
equation:

The cost of the bond credit

Where:
Ai Annuity of year i (Ai = interest i + amortization i )
Ii interest paid in year i

- annual tax savings due to interest and emission and repayment


premium expenses that reduce the total taxable income of the firm.
A special observation must be made, and that is that as long as the
interest rate can be fixed or variable, this has a special influence on the
interest flows. In the first case, the interest flows are known from the
beginning, and in the second case, these can only be estimated with a
certain probability.

exercises
1.

U.S. Treasury has just issued a five-years, $1000 bond with a 5%


coupon rate (annually). What cash flows you will receive if you hold
the bond until maturity?

CF=
2. Consider the five-years, $1000 bond with a 5% coupon rate of annual
coupons. If this bond is currently trading for a price of $957.35, what
is the bonds yield to maturity? The bond is redeemed at the end of
the fifth year. Interest Rate = 5 %
PV = - $957.35
NPER = 5
PMT= 50
FV= $1000
r=?

Example
Consider again the five-years, $1000 bond with a 5% coupon rate of
annual coupons. Suppose you are told that its yield to maturity has
increased to 6.30%. What price is the bond trading for now?
PV =
R= 6.3%
PMT= 50
FV = $1000
NPER= 5
PV= - $